9 Tips to Determine Your Investment Risk Tolerance & Spot Risky Investments
If you’re ready to start investing, the process may seem both exciting and overwhelming. It can also be tricky to know where to start. As you get ready to open an investment account or look at buying stocks to add to your portfolio, it is important to keep in mind the risks involved in investing.
When you invest in the stock market, you’re doing so with the understanding that while the investment might increase in value and earn you money, it could also decrease in value and lose you money.
This is because investing comes with risks. And understanding these risks, your personal risk tolerance, and how to spot risky investments can help you make informed decisions that are consistent with your tolerance and values.
Here are 9 tips to determine your investment risk tolerance and spot risky investments.
What is Your Risk Tolerance?
Before jumping in to determine your risk tolerance and how risky different investments are, it’s important to understand what your risk tolerance is.
Investopedia defines risk tolerance as “the degree of risk that an investor is willing to endure given the volatility in the value of an investment.” Put simply, your risk tolerance is how much risk you’re willing to take on when you invest in the stock market.
Those with a higher risk tolerance are willing to invest in more aggressive investment choices that might earn them more over time but could also lose more.
Those with a lower risk tolerance are more likely to choose less risky investments that might not earn them quite as much but also are less likely to lose them money.
A balanced portfolio is typically made up of investments of different risk levels that can help it grow but also maintain the principal.
Knowing your risk tolerance can help you pick investments aligned with your ability to take on risk and weather the ups and downs of the market as things change.
Tip 1 – Identify Your Goals
It can be hard to know what risk you’re willing to accept if you don’t know why you’re investing the money. Identifying your goals can help you develop your overall investment strategy.
When you’re working to define your goals, you’ll want to get clear on what you’re investing for. Common reasons people invest include buying a house, paying for college for their kids, or funding their own retirement.
Take time to sit down and identify the goals you’re hoping to achieve. Often, people find it helpful to write their goals down. When you define your goals, be sure you get clear on your “why.” Knowing why you’re investing can help you manage the inherent risks associated with any investment strategy.
Tip 2 – Understand Your Time Horizon
Once you’ve identified your goals, it’s important to determine your time horizon. Your time horizon for each goal is the time between when you start investing toward a goal and when you need the money.
Often goals are broken into short-term goals, where you’ll need the money in less than a year, medium-term goals, where you’ll need the money in one to three years, and long-term goals, where you won’t need the money for three years or more.
Typically, the sooner you need the funds, the less risky of an investment or savings option you’ll want to choose. This is because you don’t want losses to eat away at the principal.
Tip 3 – Figure Out How You’ll Handle Short-Term Losses
The stock market fluctuates constantly. Even if you’re invested in lower-risk options, there is the possibility of loss. Over time, the losses are typically outweighed by gains. And it’s important to know that you don’t experience the losses until you sell the investment.
An important part of figuring out your risk tolerance is knowing how you’ll deal with short-term losses. Considering your time horizon and goals, you can determine how much a short-term loss might affect your progress.
Think through how you’ll feel if you log on to your account and see a loss. If you think you’d want to pull out of an investment over a loss, it might be better to pick a less risky investment.
Tip 4 – Know Your Financial Situation
While investing can be a great way to strengthen your financial situation, you also want to take your financial situation into consideration when selecting investments.
If you don’t have an emergency fund to fall back on, it may be smart to keep some of your money more liquid so you don’t have to sell or incur fees to take care of situations that arise.
On the other hand, if you’re holding a large portion of your money in cash instead of investing it because you’re too nervous, you might want to look for some less risky investments.
This will help you feel more comfortable, and it will also help your money work for you.
Tip 5 – Develop a Plan for Tracking Your Investments
While you may not want to track your investment progress every day or even every week, it’s good to have a plan in place for how you’re going to monitor and track your investments.
Checking your investments on a regular basis can help you make small corrections if your portfolio isn’t heading in the right direction. It can also help you be sure your investments are still in line with your risk tolerance.
Pick a day every month, or in a frequency that feels comfortable to you, to sit down and check in. Keep your goals in mind. For a goal with a shorter time horizon, you might want to check in more frequently. Goals with longer time horizons could be checked in less frequently.
Tip 6 – Spread Your Risk Out Over Time
There’s a saying in the investing industry that goes, “Time in the market beats timing the market.” What this means is the longer you invest, the better your portfolio will be.
It’s virtually impossible to truly time the market. And while “buy low – sell high” is a good goal, it’s hard to pull off. Instead, you could reduce the overall risk of your portfolio by investing consistently over time.
One way to do this is to practice dollar cost averaging. To do this, you want to invest a set dollar amount on a consistent basis without paying attention to the share price. This helps reduce the impact of market fluctuations over time, so you aren’t only purchasing when prices are high. Instead, you’ll purchase the investment no matter the price, and over time the average purchase price will balance out.
Tip 7 – Look at a Stock’s Beta Value
Sometimes when you want to understand the risk of an investment, it’s helpful to understand how the individual stock’s price movement relates to the market.
To do this, you’ll want to look at the stock’s beta value. The beta value of a stock shows you how the price is expected to move as the market moves.
A stock with a beta of greater than 1.0 is more volatile than the market. This means if the market goes up, the stock will typically experience an even bigger upswing. But, if the market goes down, the stock will fall further than the market.
A beta of 1.0 tells you the stock is expected to move with the market. And a beta of less than 1.0 means the stock is expected to be less volatile than the market. Looking at the beta for a stock and understanding your risk tolerance can help you find investment opportunities with a level of risk you can live with.
Tip 8 – Be Sure You Understand the Investment
One way to spot risky investments is to look for investment opportunities you can understand.
That’s not to say you must know everything there is to know about a particular company. But, understanding the basics of a company or fund before investing in it can help you be sure you know the risks.
Through online research or talking to your financial advisor, you should be able to get a sense of what you’re investing in. If you can’t, it could be a sign that the investment is riskier, and you’ll have to decide if you want to invest in it or not.
Tip 9 – If It Sounds Too Good to be True, It Probably Is
Along with being sure you understand the investment, it’s important to remember that if an investment sounds too good to be true, it probably is. Investments that are going to double or triple your money at no risk to you don’t exist.
There is an inherent risk that comes with investing.
Be sure when you consider how much you could earn from an investment to also understand what you could lose.
Remember to think critically about your investment opportunities. Learn what you can about them and make an informed decision based on your risk tolerance, your goals, and how an investment fits into your overall financial picture.
It’s exciting to grow your portfolio over time. But investing isn’t without risk. It’s important that you understand both your personal risk tolerance and the risk presented by different investment opportunities as you get ready to invest your money.
Don’t let the possible risks scare you or stop you from investing. Instead, look at the risks as another piece of the puzzle.
Keep your goals and your time horizon front and center, and use them to help guide your investment decisions. Research your potential investments to be sure that you understand them, are ok with the risks, and that they will help you reach your goals.
If you do this, you’ll build a portfolio that reflects your risk tolerance and your goals.
If you’re ready to start investing or want to expand your portfolio, take time to identify and understand your risk tolerance. It’s a great place to start!